The ESG tech wave

ESG reporting is moving into its next phase and reaching new levels of sophistication. While the broader financial and investment market is suffering from a lack of standardisation, or too many frameworks, when it comes to figuring out which ESG metrics to adopt, new tech solutions enable fund managers to measure and report on ESG matters in all kinds of formats. And, with new EU rules coming into play, in order to comply, GPs must ensure they have the right systems in place to handle the entirely new set of ESG disclosure demands.

Against this backdrop, what can and should GPs be doing now to ensure they are effectively and efficiently gathering ESG data?

Pressure drop

When it comes to private equity’s relationship with ESG, the underlying principle appears to have been based on Peter Drucker’s famous line: “What gets measured gets managed”. However, this belief hasn’t quite played out in private markets and their ESG efforts to date.

Over the past decade, pressure from predominantly northern European pension funds has seen private equity funds adopting ESG policies and providing a level of disclosure surrounding ESG impacts.

While this new information flow has opened the door to increasing awareness of ESG matters, little has been done to correlate ESG improvement and financial returns in private capital markets. And many participants see ESG reporting simply as a time and cost burden.

Indeed, according to a report by Institutional Investor, based on Preqin and UNPRI data, there are currently 703 private equity signatories to the UNPRI. Of those, 317 report directly to the UNPRI, while 220 of that group include ESG in their reporting. However, only 16 private equity firms disclose how ESG impacts financial performance.

But LPs continue to demand more detail on ESG impacts, and this will only strengthen over the coming years. As family offices and HNWs become a larger force within private capital, they will seek managers taking ESG seriously. According to research by Savanta, which interviewed 402 HNW families with at least £5m in assets each, four in five of all generations said that responsible investing is important to them. Meanwhile, Barclays Private Bank said that changing attitudes have led to a substantial shift in the way HNW families are investing, with 78% expressing their views on social and environmental responsibility in their investments.

New rules

Beyond an increasingly demanding LP base, far more pressing is the EU’s Sustainable Finance Disclosure Regulation (SFDR), which comes into force in March 2021.

Says Mark O’Donnell, director at law firm Memery Crystal: “Essentially, it’s creating a level playing field for funds. The regulators are making an ESG investment framework and creating more harmonisation across all sectors. However, there will still be global disconnects that everyone will have to get used to, meaning a lot of the reporting is still disjointed.”

Indeed, the rules come into play after the UK leaves the EU. The UK has decided not to onshore the SFDR but instead adopt the Taskforce on Climate-related Financial Disclosures (TCFD) within the next five years rather than the EU Taxonomy aligned ruleset. While this may appear to give UK managers more time, the policy divergence will likely cause more work for those with any links to the EU. In reality, UK managers with any dealings in the EU will need to adhere to dual, non-harmonised regimes.

Whether preparing for the influence of the SFDR rules or the prospect of dual regimes, GPs need to be prepared. “Look at your existing systems and existing practices,” advises O’Donnell. “Finding out how you get the data is the biggest challenge. In terms of reporting the disclosures through the website and pre-contracts, that is more process driven, but key is having the diligence to work out how investments stack up. It’s an information exercise.”

While the new rules demand far greater transparency and detail regarding ESG impacts, they are also seeking to bring about a cultural and behavioral shift in financial markets. Rather than scoring or rating companies, the regulation takes into account what is material to each company; the landscape it operates within and the relevant risks.

Reputation costs

“Reputational risk is the message behind the new rules,” says O’Donnell. “Tick box exercises aren’t working and greenwashing is being actively prevented. This will have real consequences in attracting investors.”

Ardian began implementing its sustainability strategy back in 2009. “We have a responsibility and we also have the leverage,” explains Pierre Klemas, sustainability director at Ardian. “We always invest for the long term and we have influence as members of the board to push the sustainability agenda, which is driven by our commitment to drive real positive impacts. We always endeavour to be transparent and demonstrate to society what we’re doing and how we’re doing it.”

Data one

It is clear then that ESG is no longer a nice to have, or a tick box exercise. As we embark on 2021, ESG is creeping into every facet of asset management.

To do ESG well requires data. The first step on the ESG data journey is working out what kind of data is required. This is where the various frameworks and standards come into play. The most commonly used standards and principles in private equity are SASB, UNPRI, SDGs, ILPA, GRI, and TCFD.

It is worth noting that there is a cost involved with using these frameworks, and some GPs have developed their own programmes, which incorporate elements of each.

The next step is working out where the data comes from, and there are two distinct categories; from the inside out, or from the outside in.

Inside out

Inside out data is information collected directly from the underlying asset. Explains Klemas, “When the portfolio company enters our sustainability engagement programme we work together to develop a robust roadmap, which is very specific to each company. All the related KPIs are agreed and followed on a regular basis with the company’s management team.”

Given the complex nature of collecting ESG data, external consultants are often used to support this process.

Once the data has been collected, it needs to be stored. “Previously it was stored in spreadsheets. Today, it lives in a cloud platform we created two years ago, which integrates all the ESG data,” says Klemas. “Previously, we had all the information in separate documents, and they were also separated by strategy (buyout, infrastructure etc). If we wanted to analyse the data it had to be done manually.”

This was Ardian’s main driver for moving into a cloud based system; having all of the information in one place. “We have all the data on the platform; all the historical data since 2015 for all direct investments and fund-of-fund activities. As of today, 86% of Ardian’s AUM has been covered, providing 60,000 data points,” reveals Klemas.

With this vast dataset, Ardian’s sustainability team is able to take a consolidated view on its portfolio’s ESG activities including its carbon footprint or its diversity and inclusion efforts. “We can review it and have that intelligence. It brings efficiency in terms of reporting; we can extract what’s needed for various kinds of reports,” he adds.

While a system set up in this way clearly brings advantages when it comes to better understanding a portfolio and the ESG impacts or improvements, as well as efficiencies for both LP and regulatory reporting, perhaps the most important benefit is how it conditions the portfolio companies. “Our data management system coupled with our new sustainability measurement methodology clearly leverages our expertise to support our portfolio companies to face the biggest challenges of our time,” says Klemas.

Indeed, by working with portfolio companies to collect information themselves on areas such as its supply chain, that company is then set-up to be able to measure its own ESG impact - a major selling point at exit.

Outside in

While it may seem the inside out approach is enough to measure ESG impacts, as any historian or journalist will tell you: never rely on a single source.

When it comes to collecting the outside in data, there are currently two main players that support private markets: RepRisk and TruValue Labs. RepRisk offers a broad set of information while TrueValue uses the SASB framework.

“Outside in is really important,” says RepRisk’s EVP of sales and marketing Alexandra Cichon. “We’re looking at what the world is saying about a company, not what a company is saying about itself. We don’t tell our clients if a company has a human rights policy. Instead we look at how in fact this company manages human rights and climate issues where it operates. A policy is only an intention, what we’re talking about is performance; what is really happening.”

RepRisk is able to unearth information on private companies via publicly available information. The company consumes around 100,000 sources everyday from media, NGOs, regulators and think tanks, which is screened via its AI system. “When we’re screening the information, we’re looking for any company that has exposure to ESG risk; there are around 95 factors including corruption, human rights and pollution,” explains Cichon.

Typically, private equity firms use RepRisk’s service for pre-acquisition ESG due diligence; ongoing portfolio monitoring; and exit readiness. Beyond this, Cichon has noticed the data is increasingly used to support reporting. “Every client we work with uses it differently but we’re seeing GPs more frequently using the information in their reporting because LPs want and expect that.”

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Tech showcase: Three tech providers detail how their offerings support the rising ESG data wave

LemonTree

Jamie Nascimento, chief commercial officer

The first step is defining the metrics. It doesn’t matter if a GP is using their own framework or an existing one, it’s very easy for us to incorporate these into the system so they can be easily integrated into a GP’s own ESG strategy. We’re aiming to create as many partnerships as possible with ESG framework providers to make this a more efficient process.

The second step is populating the data. We can integrate data coming from portfolio companies across a wide variety of formats, automatically.

For external data providers, such as RepRisk or TrueValue, we can also pull this information in automatically. For example we can use a client’s RepRisk FTP service to pull in the data and automate the process.

The third step is storing the data. Yes, you could have Excel spreadsheets and input the data manually, or it goes into a system like LemonTree, which allows one source for all the information (financial and ESG).

Finally, it’s about being able to report; having a single source means you can report across both data sets (financial and ESG) in parallel. Providing information to investors and showing them how the ESG metrics have tracked over time and in correlation to your financial reports.

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Mercatus

Ali Mamujee, VP product marketing & ESG

Integrated reporting is where we’re supporting our clients today; capturing material financial, operational, and ESG data to make better decisions, capture risk, and report to LPs. The separation between ESG and financial data is disappearing in private markets. There is an ongoing trend of fund managers moving away from ESG data silos and moving towards an integrated data framework.

Our flexibility on getting data in and out is our uniqueness. Our platform allows users to configure to their needs and build out new use cases. Our no-code integration framework allows users to pull in and manage external data sets without coding. ESG frameworks are constantly changing, which requires flexibility.

Mercatus’s platform can perform rapid scenario analysis. For example, if we expect future market rates or terminal values to change, what is the impact of the overall portfolio today? With Covid, this has meant users have been able to quickly produce RAG reports for their LPs and other stakeholders.

One item in the TCFD framework requires private investors to forecast risks and opportunities. For example, what will be the impact of the overall portfolio in the event of a carbon tax, or fossil fuel bans. Other governmental frameworks are adopting the TCFD framework and requiring these forward looking disclosures. These are hugely complex tasks and we are working with our clients to actively solve this.

For SASB, which has gained tremendous traction, we have the full data set embedded in the platform. Fund managers are integrating the SASB data to their deal management and portfolio monitoring activities at the investment-level and producing portfolio level ESG risks to share with their LPs.

Mercatus also works closely with GRESB, a gold standard for real asset ESG benchmarking to support investors to streamline data collection and reporting processes.

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AtomInvest

Hemal Mehta, founder and CEO

For GPs to monitor value-add holistically, portfolio monitoring software systems need to offer a seamless and connected experience allowing GPs to track all aspects of their portfolio companies across financials, KPIs and ESG metrics.

We added lots of additional functionality to our portfolio monitoring software to track ESG performance. GPs spend lots of time during due diligence to identify ESG improvement opportunities. But often these plans will sit around after the deal is done. Our system allows you to capture the plan and then track it using hard metrics from the monitoring tool.

Another key feature is that we allow the GP to define what ESG metrics they want to track for each portfolio company. A chemicals company will be very different from an emerging market bank for instance. AtomInvest allows the flexibility to define specific metrics for each investment in a portfolio to make reporting relevant and meaningful.

Finally, the system allows you to set up data capture workflows. Every month or quarter a message goes out to the relevant people at the portfolio company asking them to supply specific metrics or complete questionnaires. This prevents having to extract that data from company reports. Once the data is captured, the GP can slice and dice the numbers; to run analyses and look at the data in many ways.

Once you have the data you can surface insights quickly. You can streamline report generation to help track, for example, the number of jobs being created in the portfolio and you can link this to whichever ESG standard your company is aligned to such as UN SDGs, or, very importantly right now, the EU SFDR framework.

When it comes to determining which ESG standard to follow, we offer two options. The first is a clean slate where the GP picks which standard/s they want to follow. Alternatively, we can seed the system with the metrics needed for a given standard and we are doing more work on integrating the various frameworks.

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Reg for more

As previously touched on, the incoming SFDR rules go far beyond disclosure requirements. O’Donnell explains, “You need to disclose in remuneration policies how individuals approach and integrate sustainability risk. When you start doing that it changes not only ESG outcomes, but also the culture; how these issues are taken seriously. It’s effecting cultural and behavioural change.”

Indeed, rather than ticking boxes and filling out forms, the new rules will undoubtedly force managers to think about ESG in an entirely new light. “We are anticipating the regulation based on the analysis of the data. This puts us in a new era to analyse and anticipate the trends. If we can extract the information easily and with high efficiency, we can be more responsive to specific questions from investors,” says Klemas.

Everything is connected

Perhaps the greatest challenge when it comes to ESG is one’s view of its impact on financial performance. Historically, ESG improvements were thought to be insulated from financial gains. And this thinking has been reflected in the way in which data is collected and stored.

Ardian currently keeps each information set separately. “Our ESG information and financial data are managed by different functions and, therefore, sit in different systems,” explains Klemas.

However, Ardian has started linking the two together. “We are now bringing companies’ ESG data via the Trustview platform in a way that our LPs can see both financial and non-financial performance at the same level,” adds Klemas.

Herein lies the deeper shift taking place when it comes to how private capital funds think about ESG, and how they manage their data. “The most successful PE firms will be the ones with the best management of data. The more data they have the more powerful they are because they can leverage those insights. Over time as they build up trends across their portfolio companies they can go back and look at what happened, and forecast based on proprietary insights, via any metric. That’s really powerful,” believes LemonTree’s Nascimento.

“I think we’re in the very earliest stages of ESG and private markets,” says Mercatus’s Mamujee. “Fund managers are finding creative ways to tell a story to LPs. Larger sophisticated fund managers see the value of this competitive differentiation; that solid ESG will lead to better alpha generation.”

“We think ESG needs to be looked at holistically,” adds AtomInvest’s Mehta. “We think deal and value-add teams also need to look at it; everyone at the GP should be aligned on the ESG value-creation plan and know what they’re responsible for. When clients look at portfolio monitoring systems, increasingly it’s not just the CFO looking at it, they’re also bringing in deal and value-add teams; they can all see the advantages of the system, of having greater insights, having clean data and ultimately better oversight on value creation.”